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Sunday, October 23, 2011

The Housing Crash: Price Drops Are Value Traps For the Unwary

Housing is down an average of 30% from its nationwide highs of 2005-07, with important variations in price among and even within individual markets. There is already a disconnect between recent achieved prices and actual values -- meaning that some buyers have bought at prices likely well below the true value of the property -- and this trend should only accelerate given the numerous factors I've explained before (and which I itemize at the end to remind you) which should depress real estate on a "macroeconomic" level for the foreseeable future.

Why Housing Is Going To Zero

This is only a slight exaggeration. Housing -- on average -- will never go to zero. Except, that is, in certain markets where there are literally no buyers for real estate inventory...at any price. The reason is that the credit bubble led to gross overspeculation. Where the speculation was in several dimensions, the damage is catastrophic.

What do I mean? Take the general, nationwide speculative bubble that spread across the nation and made people think real estate would never go down. Then consider the speculation that arose from the belief that certain proto-markets in out-of-the-way areas (think the "exurbs" some 40+ miles from a metropolitan area) would develop and lead to rapid population and jobs growth. When this latter speculation proved unfounded, when promised highways or train lines were not built, prices could and did collapse as demand evaporated. Where speculative building occurred before the evaporation, the damage was exponentially worse, with oversupply grossly outstripping virtually nonexistent demand.

In locales where demand went literally to zero...at any price...the oversupply of unused and rotting housing inventory will mean that the supply may need to be destroyed -- razed, burned to the ground, whatever -- for the pre-existing housing stock to recover its earlier 1990s value, and that even in that case, macroeconomic factors may depress purchasing power and buyer demand and keep prices barely above zero. These markets are most often found in Nevada, central California, Arizona and Florida, but can also be found in the highlands or mountainous interior of mid-Atlantic states like New York, New Jersey, Pennsylvania and Maryland.

Such locales present value traps for the unwary. There is the illusion of value from the major price drops. But just as with stocks, whose value can go straight to zero, an 80% price drop does not indicate that a price recovery (and your profit) is any likelier than a straight-down nosedive to zero (can't-be-sold-at-any-price). Let me explain how such properties are a great hedge against estate taxes, meaning: if you invest in them, you won't have an estate to tax when you die.

If you buy such a property for your primary residence, be prepared to stay put and die in that home. The general factors that blew up that market, the promised development and ensuing pullout, may continue. The surrounding area may never be developed. New highways or industries may never come. The value of the property may not fall much further, but it may never go up either. There is no assurance that the macroeconomic depression won't continue for several more years...or even decades.

If you buy that property as your residence and it is a condo, you have the additional risk of having defaulting neighbors abandon their units and sticking you and your remaining neighbors with the common charges. An insolvent or bankrupt condominium association is a value-killer for anyone who bought before the collapse. (But in my opinion it's the time to get in if you're willing to risk costs to maintain or rehab a unit and to keep the development afloat; if you can make an investment of total risk capital, meaning you can afford to lose your entire investment, perhaps it's worth considering a purchase where you buy for little more than the agreement to assume the ongoing property taxes.)

But your situation could be even worse if you rent out the property. In less populous areas, the evaporation of buyer demand often means that no one wants to live there...under any conditions. This means your target market of potential renters is likely a pipe dream that's gone up in smoke. Your investment requires rental income to be profitable, and without renters you will immediately be cash flow negative from debt service (if you've gotten a mortgage) and ongoing taxes and common charges. Almost as bad is having to take it a renter at a bargain-basement rent. This could lock you into a rental stream insufficient to give you cash flow, with uncertain prospects for being able to increase it, while you still endure the landlord risk of having a deadbeat tenant who doesn't pay and could leave your property in much worse shape than he found it.

My advice for now: Wait for the market to collapse. Mortgages are rarely being given and your competition among real estate investors is decreasing by the day. Prices will continue to fall, because of the following macroeconomic factors:

1. The overall economy is unlikely to grow in the wake of anticipated higher taxes, hidden taxes in the form of regulatory burdens like ObamaCare and Dodd-Frank, and the $14 trillion national debt for which debt service costs must be expected to increase. The result is stagflation, at best, and a prolonged recession or depression, at worst, which depresses the job market, income levels and the desire for investment in all sectors and encourages the hoarding and nondeployment of available capital.

3. Housing supply -- meaning properties on the market -- will increase at any moment when there is either a sign of a price recovery, or more likely, when other events force current homeowners to capitulate, stop holding out for the price of their dreams, and list their homes at fire-sale levels where they are willing to take virtually any offer.

4. One day, banks will push foreclosures. One day: I promise. There will -- there must -- be a day when banks no longer are willing -- or permitted -- to refuse to recognize all the nonperforming loans on their books (i.e., all the mortgages on which borrowers have defaulted). At present, there are millions of borrowers not paying their mortgages. At some point, someone will seek to make income from these properties. A glut of properties will necessarily force prices down. The alternative is a government-imposed or de facto foreclosure moratorium or restriction on all real estate transactions in a desperate effort to prevent a supply tidal wave, but which would send the catastrophic message to homeowners that they would not be free to sell their homes when they want. The ultimate result would be to do to homeowners what other countries do to entrepreneurs when they nationalize (i.e., seize) industries -- cause the capital to flee and the value to plunge as buyers demand huge discounts to compensate for the risk of buying a totally-illiquid and potentially-worthless property.

5. To the extent real estate purchases still are financed, interest rates can only rise from the sub-four percent levels currently reported. Rising rates mean increased monthly payments and diminished purchasing power. Just as plunging interest rates after 2001 helped goose the bubble in home prices, the reverse is all too easy to imagine.

If you intend to be a real estate vulture investor, I believe your patience will be rewarded.

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